**2. Theoretical framework of yield curve analysis**

According to the economic research department of the Federal Reserve Bank of New York, the analysis on the behavior of interest rates of different maturities over the business cycle goes back to the early work of Mitchell [13]. Many years later, Butler [14] made a connection between the yield curve as a predictor of short-term interest rates and the implications of declining short-term rates for contemporaneous economic activity, of which he correctly predicted that there would be no recession in 1979<sup>3</sup> . Subsequently, numerous studies have been conducted on the predictability of the yield curve in charting the future state of the economy.

Fundamentally, yield curve analysis is developed based on the term structure of interest rates, strongly associated with pure expectation theory. This theory essentially equalizes the long-term interest rates with short-term interest rates and market expectation of future interest rates plus a risk premium, which refers to the opportunity cost and compensation for holding long-term bonds as investors generally prefer short-term rather than long-term bonds. The linkage between the longterm and short-term rate together with the risk (or liquidity) premium is as presented in the equation<sup>4</sup> below;

$$i\_{nt} = \frac{i\_t + ie\_{t+1} + ie\_{t+2} + \dots + ie\_{t+(n-1)}}{n} + l\_{nt} \tag{1}$$

where *int* is the long-term rate, it is the current short-term rate; *iet+(n-1)* is the future short-term rate; and *lnt* is the risk (liquidity) premium, which posits that the yield on a long-term bond is the average of the one period interest rates expected over the lifetime of the long bond. Hence, this theory puts forward that the expectations of market participants are to be formed rationally, based on the anticipated economic situation, leading to the expected level of future short rates that would in turn influence the yields on long-term bonds.

Therefore, the link between the yield curve and growth of the economy is rationalized through the monetary policy actions undertaken by the government. For example, suppose the government undertakes a contractionary monetary policy. During this time, financial market participants would expect the short-term interest rates to be temporarily raised. If the current short-term interest rate is higher than the expected future short-term rate, the long-term rate should rise less than the short-term rate according to the expectations theory. Thus, the yield spread will be flattened, or, in extreme cases, be negative. This will also reflect situations where the yield curve will be inverted as the short-term rate is higher than the long-term rate. Inverted (or negatively sloped) yield curves have been excellent predictors of recessions for many years, whereby every recession after the mid-1960s was predicted by a negative slope—an inverted yield curve—within six quarters of the impending recession. During those times, the monetary contraction would eventually reduce spending in interest-sensitive sectors of the economy,

<sup>3</sup> Federal Reserve Bank of New York.

<sup>4</sup> Incorporating the modification into the expectation theory, with the risk/liquidity premium, widely known as liquidity premium theory, see Mishkin and Eakins [11].

causing economic growth to slow. Alternatively speaking, it just makes no sense when short-term interest rates pay investors more than the long-term bonds, and so when it does, something unusual (usually economic downturn or recession) is expected to occur. On the other hand, expansionary monetary policy would result in a high yield spread, signaling for a possibility of a higher future real economic growth, see Hamilton, and Kim [5].

motivating factors to undertake the research apart from the interest to establish the

*Has the Yield Curve Accurately Predicted the Malaysian Economy in the Previous Two Decades?*

Nonetheless, with an open economy structure, Malaysia is not exempted from economic crisis, with two of the major crises occurred within the past 20 years. One of the most significant ones was the 1997 Asian financial crisis triggered by the Thai Baht speculative trading leading to the domino effect on all Asian countries, causing the Malaysian Ringgit to be heavily sold and depreciated by almost 50% in value by January 1998, see Athukorala [27]. Coupled with the internally induced banking crisis, massive short-term and un-hedged capital inflows and sudden reversal of capital outflows have exacerbated the situation leading the massive downturn of the economy. GDP growth was recorded at negative 7.4% in 1998 from a positive growth of 7.3% recorded just a year earlier. Given the negative growth, Malaysian economy was officially down with recession, with the number of retrenchments increasing from 19,000 in 1997 to over 83,000 in 1998, while inflation rate peaked at 6.2% in 1998 surpassing the previous peak of 5.3% in 1991, see Athukorala [27]. Another notable crisis is the global financial crisis that was initiated from the credit subprime mortgage market in the US in 2007, being one of the horrendous events that has ever occurred in the world's history. The innovation acts of financial engineering to securitize and increase the liquidity of the US subprime residential mortgage-backed securities<sup>7</sup> and packaged them into collateralized debt obligations (CDOs), had turned out to be an unimaginable crisis affecting not only the US economy but the rest of the world. The downturn impact arising from this crisis for Malaysia was evident when the growth was reduced from 6.5% in 2007 to 4.7% in

Mapping the movements of the yield spread over the past two decades, it is visible that the spread turned negative prior to the two recessions in Malaysia, as shown in **Figure 1** below. Whether the inversion of the yield curve could really signal for future declining of economic output should be proven through the

*Malaysian yield spread and major recessions over 20 years. Note: The yield spread is calculated as the difference between the yields on 10-year and 3-month Malaysian Treasury securities. The shaded areas denote major*

<sup>7</sup> Subprime mortgages refer to mortagages made to borrowers who are less creditworthy than prime borrowers, see Dwyer and Tkac []. This study also presents an interesting series of events occurred

during the crisis and how the tiny market of CDOs became the triggering factor.

long-run relation of the spread with the growth.

*DOI: http://dx.doi.org/10.5772/intechopen.92214*

2008 with subsequent negative growth of 1.7% in 2009.

**Figure 1.**

*recessions.*

**155**

Putting it in a more comprehensible perspective, in general, the higher the yield on 10-year government securities relative to the yield on 3-month Treasury securitiesthat is, the more steeply sloped the yield curvethe higher the rate of future economic growth. Similarly, the less steeply sloped the yield curve, the lower the subsequent rate of growth. Hence, by looking in terms of the correlation between the two variables, it has been emphasized that the pattern of positive correlation between the current GDP growth and lagged yield spread and negative correlation between current GDP growth and future yield spread is consistent, see Wheelock and Wohar [15].

It is important to highlight that early studies on the predictability of recessions by the slope of the yield curve were primarily focused on the US economy (see Harvey [16], Stock and Watson [17], Chen [18], Estrella and Hardouvelis [1], while subsequent research tended to focus on whether the relationship between the yield spread and future economic growth still hold for other countries, apart from the US, see Harvey [19], Davis and Henry [20], Plosser and Rouwenhorst [21], Bonser-Neal and Morley [22], Kozicki [23], Estrella and Mishkin [3], Estrella et al. [24]). Some other studies have also empirically proven that the spread contains useful information about the future path of inflation (Jorion and Mishkin [25], Gerlach [26]).

With regard of the different views on the predictive power of the yield curve over time, particularly in Malaysia, the present study develops a model to examine the ability of the yield spread to predict economic growth over a longer time horizon, within two decades. An overview on the Malaysian economy and major crises over the last 20 years is also presented in the next section.
